Wednesday, October 22, 2008

Pushing on a String

I wanted to plant the seed on this one, it really deserves much more conversation: the money multiplier may work on the way in, BUT ALWAYS works on the way out.

Our financial markets are based on a fractional reserve banking system. Simply put, a lending institution is allowed by regulators to lend out more money than it has accepted in deposits. If a bank secures $100 in deposits, it is possible for the bank to create roughly $1,000 in loans. Let's take a look....

A bank is required to hold on reserve only a fraction of the deposits it garners. Only a fraction is held because it is postulated that depositors don't redeem their deposits at one time. The required reserve ratio is set by the Federal Reserve. The current ratio is tiered, based on bank size and deposit type.

Let's use 10% for sample calculations: a customer deposits $1,000 in a bank. The bank is required to hold $100 in reserve with the Fed and can lend $900 out. The customer who borrows that $900 buys a TV. The store owner takes the $900 check and deposits it in his bank (possibly the same bank as the borrower secured his loan from, but the net effect on the banking system are the same even it is a different bank). The process continues: the bank holds $90 in reserves and can lend $810. The end result is that the initial $1,000 deposit can create $10,000 in money supply: $1,000 * (1/0.10) = $10,000.

The caveat: banks do not have to make the maximum amount of loans. All we know is that there is somewhere in between $1,000 and $10,000 introduced into the system.

However, when the customer withdraws that $1,000, the net impact on the system IS a drop of $10,000. In an earlier post, I mentioned that the Fed was in a race to put money into the system at a faster rate than it was being removed. This is compounded by the fact that the Fed can't control how many loans are made with the additional liquidity (pushing on a string). If banks choose to be conservative, the Fed must over-supply the market with funds relative to the anticipated amount of money creation implied by the reserve ratio.

Loan defaults deplete the system, just like withdrawals. So each time you here about a $1 billion of loans written off and not recovered, $10 billion have just been removed from the system.

"The voyage of the best ship is a zigzag line of a hundred tacks. See the line from a sufficient distance, and it straightens itself to the average tendency. Your genuine action will explain itself, and will explain your other genuine actions. Your conformity explains nothing."

Ralph Waldo Emerson

"We're all faced throughout our lives with agonizing decisions, moral choices. Some are on a grand scale, most of these choices are on lesser points. But we define ourselves by the choices we have made. We are, in fact, the sum total of our choices. Events unfold so unpredictably, so unfairly. Human happiness does not seem to have been included in the design of creation. It is only we, with our capacity to love, that give meaning to the indifferent universe. And yet, most human beings seem to have the ability to keep trying and even to find joy from simple things, like their family, their work, and from the hope that future generations might understand more."